The bond/gilt market

Mikeeee_2

There have been some interesting things come up in other threads so I thought I'd put something together for general discussion. In order to understand the stock market, it is incredibly useful to first understand the Bond market.

Why should I understand bonds?

Both bonds and stocks are two of the main investment option choices open to investors but the bond market is generally considered to be around 2.5-3 times the size of the stock market. Bonds are also known as 'Fixed Income Securities' - a fancy way of telling you that if you loan your money to someone, they will pay you a fixed amount of money every year in return for your loan. By understanding the returns currently available in the bond market it can help you understand what you should be aiming to beat if you invest in the stock market.

Who offers bonds?

If you invest in a bond you are lending your money to someone else in return for some form of return. The return to the investor is referred to as the "yield" but needs to be calculated in relation to the price - more on this later. Broadly speaking, there are two main types of bond to understand.

Government - In the UK, the government issues "gilts", a fancy shorthand of "Gilt edged securities" - also referred to as "treasuries" and called gilts because they used to be issued on posh bits of paper with a golden edge. I digress. These gilts are about as safe and secure an investment that you can get. If you think the UK government is ever going to go bankrupt (knowing that it controls the Bank of England who have licence to print money) then the stock market would crumble too, so this is not something I would waste time worrying about. The government issues these gilts over a variety of durations. Short duration gilts are 5-7 years or less, mediums are 5-7 to 15 years and longs are over 15 years. There's a slight discrepancy between what the government considers short and what the financial press does.

Retail & Corporate Bonds - These are issued by companies (like Tesco, banks, insurers, utility companies etc) and are considered higher risk than government bonds. For that higher risk of default, investors are usually offered a higher rate of return than a government bond and the yields usually reflect this accordingly. If you can get a government bond paying you around 4.5% each year, be very wary of a company paying 12%! You really need to look at the company in far more detail and scrutinise its financial reports. Look carefully at the credit rating and weigh the risk.

Par value

The vast majority of these bonds and gilts have a "par value" of £100. Simply put, the par value is how much money you will get back when the bond reaches the end of its life, otherwise known as the "maturity date". Nobody ever really buys into the bond at par value, they will either be above or below par, from which you can work out the al important yield.

Risk free return

Considering the above, let's consider a UK gilt as a cast iron investment. I acknowledge there is an argument against that statement but it is fair to say that it is safer than any other investment on the LSE. You can currently buy a 4.25% Gilt at a dirty price (more below if interested) of £98.32 at the time of writing. This means that you will receive 4.25% of the par value, so £4.25 for every gilt you buy at £98.32, which is a yield on your investment of 4.32% - higher than the stated 4.25% as the price is below par. The gilt matures in December 2049 so if you hold until redemption you will receive that coupon every year plus the shortfall of £1.68 between the dirty price you paid and the par value when the gilt matures. This effectively gives you a risk-free return of 4.38%.

This, very obviously, does not take inflation risk into account which will likely erode the value of your capital over time. When we talk about risk here, it is in relation to the initial capital.

So why is that important?

If you are investing in the stock market you are taking on a much higher degree of risk. There is more chance of losing some or all of your money. So you need to ensure that your returns are higher than 4.68%. Otherwise, what's the point of all the stress, research and risk?

Interest Rate Effect

Now if the Bank of England brings down the base rate by say, 1%, the market price of this particular gilt will adjust by approximately 15.50% upwards. Therefore, you could be sat on a gilt now worth approximately £107.24 and still collecting the £4.25 each year. So you could either sell or wait for the base rate to fall further for more gains.

Try not to be swayed by the name of the bond. It will always look more attractive to buy a 6% or 8.25% named bond but the YIELD is the most important consideration.

This is meant as an overview and not intended to encourage you to buy bonds. This was just about how the massive bond market works and why you should consider it in relation to the stock market. Always DYOR.

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Some more stuff if you're interested.

How do you receive money?

You may have heard of the term "coupon". Again, this is a fancy way of telling you how much money you will receive in relation to the par value. Gilts are almost always paid twice a year with corporate and retail once or twice a year.

If you hold a bond within a tax wrapper (like a pension or ISA) then there is no tax to pay on income received from the coupon nor Capital Gains Tax (CGT) should you sell the bond/gilt for a profit.

Conventional and Index linked
Conventional bonds pay a set amount of coupon, usually twice a year. These are the easiest to calculate and provide a great deal of certainty. Index linked gilts usually pay a very small coupon (something like 0.1% for instance) but the interest accrued is taken directly from the RPI. So if you think we're about to go through an extended period of high inflation, these are a good hedge against that.

Clean price and dirty price

The clean price is the currently market price and the dirty price is the clean price plus the amount of interest that is built up since the between the interest dates. You pay the dirty price when you invest in a bond to compensate the seller for holding it up to that point.

Inverted Yield Curve

This is another complicated term but effectively means that sometimes, the yield you are getting from longer term bonds is lower than shorter term bonds. This is caused by higher short term interest rates but investor expectations that interest rates will fall rather than rise from its current position in the foreseeable future. The inverted yield is a fairly accurate predictor of a recession or a downturn in the economy. This is what we have recently been through.

Is now the best time to buy bonds?

If you believe that interest rates will fall then absolutely, this is probably the best time to buy. If you think they will rise then no. If you hold the bond until maturity then the rise and falls do not matter a jot.

sevenhills

Short duration gilts are 5-7 years or less, like holding a 5 year fix in a savings account, you cannot sell early?

Are the dealing charges similar to buying shares, a £1,000 holding for example or are bonds just for the big money people?

Mikeeee_2

sevenhills said:

Short duration gilts are 5-7 years or less, like holding a 5 year fix in a savings account, you cannot sell early?

Are the dealing charges similar to buying shares, a £1,000 holding for example or are bonds just for the big money people?

It depends on your platform/broker. I hold mine on ii and I get a couple of 'free' trades each month. But you can hold small amounts. I recently bought £2000 worth TR56 and £2000 of TR63 within my ISA without any issue. There is also a secondary market to sell on.

Mikeeee_2

sevenhills said:

Short duration gilts are 5-7 years or less, like holding a 5 year fix in a savings account, you cannot sell early?

Are the dealing charges similar to buying shares, a £1,000 holding for example or are bonds just for the big money people?

Here's the current gilts available sorted by Modified Duration. In theory, that's the amount the gilt price changes with a 100bps BoE cut. Gross redemption yield is the column to the right.

Bobziz

Very useful, thank you @Mikeeee_2 Could you explain the 14.96% calculation please.

Mikeeee_2

Bobziz said:

Very useful, thank you @Mikeeee_2 Could you explain the 14.96% calculation please.

It's quite a complex formula but the Modified Duration (which is the % above) is derived from the Macaulay Duration:

Johnjdc

sevenhills said:

Short duration gilts are 5-7 years or less, like holding a 5 year fix in a savings account, you cannot sell early?

Are the dealing charges similar to buying shares, a £1,000 holding for example or are bonds just for the big money people?

You can sell early, you just might lose money depending what the market is doing.

Whereas if you hold to maturity, you will get a particular value with as close as can be to absolute certainty.

Dealing charges are often similar to shares, but no stamp duty - though there will be some spread between bid and ask.

My benchmark has tended to be that short-ish gilts are worth it for sums over £10k, at the moment - but it depends what else you'd do with your money, your tax rate, etc etc.

They are most worth it for higher rate taxpayers with enough savings that they would otherwise be paying for 40%, who can buy low coupon gilts and get an untaxable capital gain instead of income.

shortseller09

Mikeeee_2 said:

Interest Rate Effect

Now if the Bank of England brings down the base rate by say, 1%, the market price of this particular gilt will adjust by approximately 14.96% upwards. Therefore, you could be sat on a gilt now worth approximately £107.24 and still collecting the £4.25 each year. So you could either sell or wait for the base rate to fall further for more gains.

Nice intro to the subject, so it may be worth clarifying the calculation behind this.

Mikeeee_2

shortseller09 said:

Mikeeee_2 said:

Interest Rate Effect

Now if the Bank of England brings down the base rate by say, 1%, the market price of this particular gilt will adjust by approximately 14.96% upwards. Therefore, you could be sat on a gilt now worth approximately £107.24 and still collecting the £4.25 each year. So you could either sell or wait for the base rate to fall further for more gains.

Nice intro to the subject, so it may be worth clarifying the calculation behind this.

Yes it's quite a complex formula. I responded with a reply to it above. Bit tricky to demonstrate easily on the forum. Thankfully, you can use something like SharePad to do all the legwork for you.

zagfles

The section headed "risk free return" is misleading because it completely ignores inflation risk. You buy a flat gilt maturing in 2049, yes you'll get a guaranteed return in nominal terms, and if you hold till 2049 you'll get £100 then, but you have no idea whatsoever how much £100 will buy you in 2049. Maybe a round in the pub. Maybe a pint. Who knows. But £100 in 2049 is not going to be the same as £100 today - that is virtually certain. So you don't know the real maturity value. You are taking a risk, in the same way as taking a risk on the stockmarket (you can argue the level of risk is different - but it's still a risk).

Mikeeee_2

zagfles said:

The section headed "risk free return" is misleading because it completely ignores inflation risk. You buy a flat gilt maturing in 2049, yes you'll get a guaranteed return in nominal terms, and if you hold till 2049 you'll get £100 then, but you have no idea whatsoever how much £100 will buy you in 2049. Maybe a round in the pub. Maybe a pint. Who knows. But £100 in 2049 is not going to be the same as £100 today - that is virtually certain. So you don't know the real maturity value. You are taking a risk, in the same way as taking a risk on the stockmarket (you can argue the level of risk is different - but it's still a risk).

The risk free return is what you'll get in absolute terms. It is completely known. Inflation risk is something else. By investing in the stock market, you should beat inflation but as a minimum you should be looking to beat the bond market return. Otherwise, what's the point? It's intentionally there to make people realise they can get that return guaranteed. If you want that plus inflation protection then you go down the route of RPI index linked gilts. So I disagree that it's misleading. It's a benchmark figure.